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enFive Years Laterhttp://www.fortnightly.com/fortnightly/2013/10/five-years-later
<div class="field field-name-field-import-deck field-type-text-long field-label-inline clearfix"><div class="field-label">Deck:&nbsp;</div><div class="field-items"><div class="field-item even"><p>Wall Street is back in business. What’s next for utility finance?</p>
</div></div></div><div class="field field-name-field-import-byline field-type-text-long field-label-inline clearfix"><div class="field-label">Byline:&nbsp;</div><div class="field-items"><div class="field-item even"><p class="p1">Michael T. Burr</p>
</div></div></div><div class="field field-name-field-import-bio field-type-text-long field-label-inline clearfix"><div class="field-label">Author Bio:&nbsp;</div><div class="field-items"><div class="field-item even"><p class="p1"><b>Michael T. Burr</b> is <span class="s1"><i>Fortnightly’s</i></span> editor-in-chief. Email him at <a href="mailto:burr@pur.com">burr@pur.com</a></p>
</div></div></div><div class="field field-name-field-import-volume field-type-node-reference field-label-inline clearfix"><div class="field-label">Magazine Volume:&nbsp;</div><div class="field-items"><div class="field-item even">Fortnightly Magazine - October 2013</div></div></div><div class="field field-name-field-import-image field-type-image field-label-above"><div class="field-label">Image:&nbsp;</div><div class="field-items"><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-fig1.jpg" width="1022" height="1025" alt="Figure 1 - Big Build and the Great Recession" title="Figure 1 - Big Build and the Great Recession" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-Napolitano.jpg" width="1002" height="849" alt="&quot;Capital markets are vibrant and healthy. It feels like the end of a five-year cycle of fear and distress.&quot; - Frank Napolitano, RBC Capital Markets" title="&quot;Capital markets are vibrant and healthy. It feels like the end of a five-year cycle of fear and distress.&quot; - Frank Napolitano, RBC Capital Markets" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-fig2.jpg" width="1026" height="907" alt="Figure 2 - Power &amp; Gas Debt Issues" title="Figure 2 - Power &amp; Gas Debt Issues" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-Bilicic.jpg" width="1002" height="841" alt="&quot;There’s a sense that regulators are suffering from rate-filing fatigue, and rate proceedings will become more difficult.&quot; - George Billicic, Lazard" title="&quot;There’s a sense that regulators are suffering from rate-filing fatigue, and rate proceedings will become more difficult.&quot; - George Billicic, Lazard" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-fig3.jpg" width="2056" height="783" alt="Figure 3 - Major Power Asset Acquisitions" title="Figure 3 - Major Power Asset Acquisitions" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-Kind.jpg" width="1002" height="841" alt="&quot;If a company will sell assets in this market, it’s not because they think they’ll get good proceeds.&quot; - Peter Kind, Energy Infrastructure Advocates" title="&quot;If a company will sell assets in this market, it’s not because they think they’ll get good proceeds.&quot; - Peter Kind, Energy Infrastructure Advocates" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1-Nastro.jpg" width="1006" height="851" alt="&quot;Investors will start differentiating utilities by regulatory compact.&quot; - David Nastro, Morgan Stanley" title="&quot;Investors will start differentiating utilities by regulatory compact.&quot; - David Nastro, Morgan Stanley" /></div></div></div><div class="field field-name-body field-type-text-with-summary field-label-hidden"><div class="field-items"><div class="field-item even"><p>When the storied investment bank Lehman Brothers declared bankruptcy on Sept. 15, 2008, it marked the official beginning of the worst financial crisis in recent history.</p>
<p>The fact is, however, that by the time Lehman went bankrupt, a crisis already had been brewing for at least 18 months. The subprime lending meltdown began in early 2007, when median home sales prices in the United States began sharply declining from their January peak. By the end of 2007, the subprime mortgage crisis was looking like a debt crisis generally, and we were already talking about a recession and its possible effect on utilities. </p>
<p>Specifically, in our October 2007 financial report, we wrote: “the industry’s financial health arguably has nowhere to go but downward in the months and years to come. </p>
<p>“Utility companies are bringing monumental capital expenditure plans before rate regulators just as they’re dealing with a barrage of rising costs – for fuel and other commodities, as well as labor, pension-fund obligations, and interest payments. Additionally, with the threat of greenhouse-gas (GHG) regulation looming in the 2009 to 2013 time frame, utilities face unpredictable environmental-compliance costs. </p>
<p>“Many utility companies and their investors expect regulators will support utilities’ capital requirements with progressive rate structures, including accelerated rate-recovery for cap-ex spending. But as costs escalate, utilities’ rate demands seem certain to test the limits of regulators’ support.” (<i>See “</i><a href="http://www.fortnightly.com/fortnightly/2007/10/2007-finance-roundtable-pricing-regulatory-risk" target="_blank"><i>2007 Finance Roundtable: Pricing Regulatory Risk</i></a><i><a href="http://www.fortnightly.com/fortnightly/2007/10/2007-finance-roundtable-pricing-regulatory-risk" target="_blank">,</a>”</i> <i>October 2007.</i>) </p>
<p>Those predictions – a full year before the official start of the financial crisis – were mostly accurate. But as it turns out, we missed some things. For one thing, we didn’t predict that the debt markets would actually freeze up in the depths of the crisis. We didn’t imagine the financial meltdown would pull down Lehman Brothers, and drag some other banks so close to the brink that Congress would step in with the $700 billion Wall Street bailout. And we didn’t know that the ensuing economic decline would get its very own proper noun: the Great Recession.</p>
<p>Moreover, we didn’t know that natural gas prices would plunge and stay down in the low single digits per million Btu, driven by a slow economy and a boom in shale development. We did guess that interest rates would decline, but we didn’t understand just how far the Federal Reserve would go to pump money into the economy. As Treasury rates flirted with the number zero, utilities began refinancing their bonds to free up cash flow. Then, Congress passed an economic stimulus bill that provided bonus depreciation for capital investments, which in many cases allowed utilities to invest without raising much debt or equity capital. </p>
<p>These factors brought remarkable results in the electric and gas industry. Utilities plowed money into infrastructure all through the Great Recession (<i>see Figure 1</i>) – a trend that we actually did predict in October 2008, as we saw investment costs declining and policy changes on the way. “[S]ome companies might accelerate their investments, taking advantage of falling prices for building materials and labor, and an increase of available contractors in a slowing industrial market. Plus, if political winds continue blowing in their current direction, the industry might benefit from a wave of financial incentives for capital investments and energy technology development and demonstration.” (<i>See “</i><a href="http://www.fortnightly.com/fortnightly/2008/10/path-forward"><i>The Path Forward</i></a><i>,”</i> <i>October 2008.</i>) </p>
<h4><b>Harnessing Headwinds</b></h4>
<p>The path the industry has taken since 2008 has been influenced substantially by government policy changes and incentives. Most notably, the American Recovery and Reinvestment Act of 2009 (ARRA) provided extra impetus for smart metering and other distribution technology investments that companies otherwise might’ve put on the back burner. In addition, FERC incentive rates and remotely sited renewable energy development drove transmission investments. Renewed and enhanced federal tax credits spurred major investments in utility-scale wind and solar farms. New EPA regulations prompted major environmental upgrades and retrofits. And gas safety standards – prompted by tragic disasters at aging pipelines – sparked gas distribution investments. </p>
<p>As a consequence, investor-owned power and gas companies spent $400 billion on U.S. capital projects between 2008 and the end of 2012. Even more remarkably, throughout this period of heavy investment, despite the suffering economy and anemic energy markets, investor-owned utilities generally maintained positive cash flow, strong dividends, excellent credit metrics, and easy access to capital markets.</p>
<p>“The regulated utilities sector has actually done a little better than we’d originally projected in our financial models,” says James Hempstead, a senior vice president with Moody’s Investors Service. He cites tax benefits like bonus depreciation, as well as a stable regulatory environment. “Across the country, regulatory agencies have been very supportive for utility cost recovery, providing decisions on a timely basis and approving a series of trackers and rate riders for single-issue recovery mechanisms. We think that’s a good thing, because it provides a degree of transparency and timeliness to cost recovery.”</p>
<p>The same observations can’t, however, be applied to unregulated power companies, for whom low commodity prices and a flight to quality on Wall Street have resulted in a starvation diet. “Companies are hunkering down to protect liquidity,” Hempstead says. “They’re harvesting assets and squeaking out efficiencies to improve cash flows. It’s been a difficult market for the unregulated power sector.”</p>
<p>Indeed, several major independent power companies have gone through major financial distress in the past five years:</p>
<p>• AES Eastern Energy filed bankruptcy at the end of 2011. </p>
<p>• Bicent Holdings and 12 of its affiliates sought bankruptcy protection in April 2012. </p>
<p>• GenOn saw its share prices plunge from more than $25 in 2007 to less than $2 when NRG Energy agreed to acquire the company in July 2012. </p>
<p>• Dynegy filed Chapter 11 in July 2012. </p>
<p>• Edison Mission Energy filed bankruptcy in December 2012. </p>
<p>Today, with power prices remaining persistently low, the difficulty isn’t over for unregulated power companies. At this writing, analysts were predicting a November 1 bankruptcy filing for Energy Future Holdings subsidiary Texas Competitive Electric Holdings, which includes wholesale generator Luminant and retailer TXU Energy.</p>
<p>Some other unregulated power companies are selling off generating assets – sometimes despite weak market valuations – in an effort to buttress their balance sheets. Secondary market activity also is driven by strategic moves among unregulated generators and utilities, as well as the investment cycles of private equity funds and institutional investors seeking to capture what value they can from mature assets languishing in their portfolios. (<i>See Figure 3.</i>)</p>
<p>Further, some companies are exploring options for capturing higher valuation multiples from portfolios of similar assets – most notably through so-called “yieldco” (yield company) and master limited partnership (MLP) structures. In March, for example, OGE Energy, CenterPoint Energy, and ArcLight Partners agreed to form an MLP that will own OGE and CenterPoint’s interstate pipelines, midstream, and field services businesses, with the intent of raising equity through an initial public offering (IPO). And in July, NRG raised $462 million through the IPO of NRG Yield, an investment vehicle for several generating plants and development projects with long-term power purchase agreements. </p>
<p>To better understand how the industry has weathered the past five years – and how it’s positioned for the years to come – we spoke with several finance executives. </p>
<p>• Peter Kind, Energy Infrastructure Advocates</p>
<p>• Matt LeBlanc, JPMorgan Chase</p>
<p>• George Bilicic, Lazard</p>
<p>• David Nastro, Morgan Stanley</p>
<p>• Frank Napolitano, RBS Capital Markets</p>
<p>• James Hempstead, Ryan Wobbrock, Mike Haggerty, and Jeffrey Cassella, Moody’s</p>
<p>Their perspectives suggest America’s power and gas companies will continue to find a welcome reception on Wall Street – even as they face an increasingly complex future.</p>
<p><b>FORTNIGHTLY</b> It’s been five years since the financial crisis began. How has the power and gas industry weathered the crisis? What’s the general outlook for access to capital today?</p>
<p><b>Napolitano, RBC Capital Markets:</b> Five years after the start of the worst financial crisis in recent history, and the markets are as open as they were before, and even more open in terms of available capital products and investors for those products. </p>
<p>Last year we could’ve said IPOs were possible for contracted renewable companies, subject to market conditions and pricing. Since then we’ve seen successful IPOs of yieldcos. Most recently Pattern Energy announced its IPO. [The company planned to raise $320 million.] MLPs and yieldcos are a hot trend in power and gas financing. </p>
<p>In general capital markets are vibrant and healthy. Costs for issuing securities are better than they’ve been 95 percent of the time. It hasn’t felt this way since 2006, and the fundamentals are rational. It feels like the end of a five-year cycle of fear and distress.</p>
<p><b>Nastro, Morgan Stanley:</b> Year-to-date, we are very close to the 20-year record that was set for corporate debt issuance in 2007. Corporate boards are gaining confidence and are more comfortable borrowing money than they’ve been at any time since the financial crisis. </p>
<p>Historically, lower Treasury yields correlated with higher investment-grade credit spreads. But if you look at 2012 and 2013, markets dislocated from this trend and we’ve seen only a modest widening of spreads. The combination of historically low Treasury yields and relatively tight credit spreads has translated into historically attractive financing costs.</p>
<p>In the leveraged finance market, we’ve seen the technical underpinning improving, with the refinancing wave from 2010 to the present. Near-term maturities have either been refinanced or addressed through amend-and-extend transactions. The leveraged finance market continues to be healthy coming out of the crisis, and we expect to see further issuance with the expansion of European and international markets. </p>
<p>Coming out of the Eurozone banking crisis, the old project finance banking market is significantly weaker than it was. Bank downgrades and Basel III requirements have forced banks to shore up their capital levels. Fewer banks are providing capital and generally are lending only to core relationship clients, with higher fees and pricing. But as traditional project commercial lenders exit that market, the capital markets have been filling the void. Capital market investors have ample capacity and a desire for structured bonds. As investors continue searching for yield in a low interest-rate environment, they’re more interested in structured credits. </p>
<p><b>Bilicic, Lazard</b>: Utilities continue to provide a very attractive risk-adjusted total return proposition to shareholders, because of the dividends they offer and some reasonable growth that goes along with that dividend proposition. This has been particularly important in the volatile equity markets over the past few years, and has allowed utilities to offer a differentiated and useful investment proposition.</p>
<p>Going forward, the industry could start to cycle into a period with modestly increased earnings challenges driven by load-growth issues, rate pressures, and other factors. Some industry participants will be successful in addressing these earnings challenges and some might not. Further, while it is tiresome for industry participants to hear this observation, long-term interest rates eventually will begin rising, placing pressure on valuations and the need to show growth.</p>
<p>These potential negative trends could affect valuation levels, but if one views the historical access to capital for the utility industry and the depths of the relevant capital markets, it’s hard to see how capital markets access – as opposed to valuation levels – will be impaired in any material manner. </p>
<p><b>Haggerty, Moody’s:</b> The industry has been incredibly resilient. We remember the dour mood at the EEI Financial Conference in 2008, but the sector was still accessing the markets because there was a flight to quality.</p>
<p>Low gas prices and low interest rates have been big contributors to the credit quality of the sector. Interest rates might go up, but not quickly or immediately, and companies should be able to adapt. </p>
<p>Bonus depreciation has been helpful, and it’s kept metrics inflated a couple of percentage points higher than they’d normally be. As that comes off, it could put pressure on metrics and challenge companies’ ability to keep up capital spending without going in for a rate case. It’s not a game changer, but something management has to deal with going forward.</p>
<p><b>LeBlanc, JPMorgan Chase:</b> Sophisticated utilities with access to capital markets have turned their debt over to lock in low fixed coupon rates. As issuers, they’re focused on maintaining investment-grade ratings as a core commitment to regulators and customers. </p>
<p>We focus mostly on the project financing and structured financing market. With pressure on European banks and insurers related to regulatory capital adequacy, you have fewer players in that space. Some Canadian, Japanese, and U.S. banks are participating, but with fewer capital providers, you see spreads widenening.</p>
<p>We see a huge opportunity in the U.S. to deploy money in the energy and power value chain, especially midstream and closer to the demand side. We think it’s a $1 trillion investment opportunity over 10 years – and that’s all new money going in, not considering existing assets that might change hands. </p>
<p><b>FORTNIGHTLY</b> Utilities are facing pressure on both allowed returns on equity (ROE) in rate cases, and earned ROEs. How does pressure on ROEs affect utility financing and access to capital?</p>
<p><b>Kind, Energy Infrastructure Advocates:</b> Low interest rates have led to low ROEs, and that creates a competitive dynamic. As other states look to what’s being granted by neighboring states, it focuses attention on keeping rates reasonably low. </p>
<p>Earned ROEs are where the rubber meets the road, and they have lagged allowed ROEs. In a market where load growth is modest – or nil – investors are concerned about a company’s ability to earn its allowed ROE. Coverage ratios go lower, and that affects your credit metrics. It’s a cycle.</p>
<p><b>LeBlanc:</b> Regulators are saying ROEs should come down as financing costs come down. But that makes it difficult in a rising-rate environment, when you’re no longer competitive with other entities that are issuing debt. It will put utilities in a bind, if and when these things play out. </p>
<p><b>Napolitano: </b>Pressure on ROEs is coming in utility rate cases. We’ve seen a variety of regional outcomes. ROEs in the Southeast are generally higher than in other regions. The exercise for utilities now is to get what they need for reliability and green power investments, without accelerating costs onto bill payers. </p>
<p><b>Nastro:</b> We’re concerned that as interest rates start moving up, we might not see a commensurate rise in ROEs on a timely basis. </p>
<p>Because ROEs are facing downward pressure, utilities are reluctant to file general rate cases. They’re asking regulatory commissions to provide forward-looking recovery mechanisms to reduce lag, such as trackers that allow them to stay out of rate cases for longer and a focus on managing non-fuel O&amp;M costs. Investors likely will start differentiating utilities by regulatory compact. They’ll seek shelter in this rate storm with utilities in states like California and Illinois, where the ROE construct has some degree of interest rate protection.</p>
<p><b>FORTNIGHTLY</b> Several large mergers were completed in the last couple of years. Now only one major transaction is pending – MidAmerican Energy’s acquisition of NV Energy. What factors are affecting utilities today as they consider M&amp;A activity?</p>
<p><b>Nastro:</b> Buyers have been aggressive as they try to pry loose non-core regulated assets. For example, Laclede bought Missouri Gas [for $975 million, closing September 1], and TECO Energy is acquiring New Mexico Gas [for $950 million, closing expected in early 2014]. Those sales resulted in robust auctions with strategic and financial buyers lowering their hurdle rates as they actively look for new growth opportunities. Regulated utilities are also looking to take advantage of their strong currency and historically low financing costs to make things happen.</p>
<p>MidAmerican wasn’t alone in looking at the opportunity to acquire NV Energy. Other strategic buyers also looked at that business and were willing to reach geographically for new growth avenues. There are a limited number of contracted and regulated opportunities out there, and we’ve seen aggressive buyers and long lines in recent auction processes.</p>
<p><b>Kind:</b> Each transaction has its own rationale. The themes that have driven deals are management succession issues, the need for synergies to mitigate rate increases, or scale to support raising capital. I suspect that over the next several years, rate-case activity will be fairly active, and that might put a dent in the level of M&amp;A activity. It’s not typically conducive to seek merger approval while you’re processing a rate case. This might be less of a factor for the big companies that are always processing rate cases, but for smaller companies, the single-state utilities, it’s harder to do.</p>
<p>Also it’s fair to say that when deals are announced, the companies that aren’t involved will reassess the landscape. Companies don’t want to be left out if there are potential partners they want to pursue. They start asking questions, and that’s how a wave gets started. </p>
<p>For companies whose valuation is dependent on power prices, their stocks are being challenged, and they don’t have a strong currency right now to consider acquisitions. At some point they might consider strategic acquisitions to create scale. But in general low commodity prices aren’t helpful to the stock prices of merchant players, and they’re holding back, trying to figure out how to stabilize their profitability. </p>
<p><b>Bilicic:</b> M&amp;A activity ebbs and flows, but there is a consistent story across the industry – it’s consolidating slowly and steadily. At the moment there are something like 52 publicly traded electric utilities. Twenty years ago, there were 95 or 96. We expect consolidation to continue, because value can be created through M&amp;A that can materially exceed the stand-alone case. While some will move forward smoothly, others will struggle as a result of regulatory approval issues and questionable industrial logic. </p>
<p><b>LeBlanc:</b> It varies from one jurisdiction to another, but companies tend to view themselves as fully valued in the current stock market. Nobody wants to buy at the top of the market. </p>
<p>I think it will get harder for companies to merge. That creates an opportunity for private capital to come in. It won’t be a panacea but it can provide capital in partnering situations.</p>
<p><b>FORTNIGHTLY</b> We see a strong flow of asset deals lately. What’s driving that activity and how are asset M&amp;A trends and strategies evolving?</p>
<p><b>Kind:</b> To the extent you’re holding a merchant generation asset in a low power-price environment, your profitability has been affected. The asset market is pretty challenged. While power prices remain low, it will continue to be a buyer’s market. If a company will sell assets in this market, it’s not because they think they’ll get good proceeds, but because they need to reduce risk factors. Some distressed companies might need to sell assets to raise cash, or they’ll be taken over in bankruptcy and the new owners will sell those assets.</p>
<p><b>Napolitano:</b> Because the debt markets are wide open and available at all levels of credit quality, buyers can build a capital structure to acquire assets for cash. This is a point of progress. In 2008 there was no M&amp;A because there was no access to capital. In 2010 the market started to come back, and in 2011 and 2012 companies were more and more successful. Now in 2013, the buy side is well capitalized again, and the market is wide open, with buyers and sellers of everything – midstream, coal, gas, renewables, you name it. In my entire career, I’ve never seen more things for sale, of all types, in the U.S. power and utility asset space. </p>
<p>In some cases, the owners are private equity funds and they’ve reached the end of a hold period, and they need to cycle capital. In other cases, strategic investors are simplifying their business models. Ameren is an example; the company’s non-investment grade genco wasn’t creating shareholder value, so Ameren decided to exit the business. Some companies are bolstering a business that they consider to be their core, or entering one that seems to have better growth prospects. </p>
<p>When you have that kind of market, with many different participants, people start to aggregate assets around strategies: bringing a portfolio together and finding buyers; or seeking uplift through a public offering; or just operating the portfolio. There’s a belief in the market that valuations will improve from where they are today.</p>
<p>In that belief are the roots of recovery – and it’s happening in spite of the fact that demand for the underlying product isn’t going up. I think it’s healthy that participants are able to build a capital structure that works with the uncertainty.</p>
<p><b>Nastro:</b> The lack of organic growth is pushing management teams to look at strategic alternatives to provide upside for shareholders. Investors continue to reward transactions with a clear, coherent strategy, and a shift toward a more pure-play business model, with the ability to build scale and bring competitive advantages.</p>
<p>Several diversified utilities own merchant generation assets and their stocks are reflecting limited equity value for these businesses. There are advantages for power generation being held in a pure play, publicly traded merchant genco. If you think about how a merchant IPP is valued in the public markets, investors focus on EBITDA and cash flow, compared to earnings per share and capital structure for utilities. It’s a different valuation methodology, and IPP investors are comfortable with a company that’s non-investment grade. </p>
<p>Since the equity market trough in 2009, interest-rate sensitive stocks have outperformed in the context of a low rate environment. Investors have been searching for new yield-oriented products. NRG Yieldco, for example, demonstrated a compelling growth profile in addition to traditional yield. In some situations, renewables and contracted fossil assets can be more appropriately valued in a yieldco construct than they can in a traditional utility or IPP model. These structures can result in a lower cost of capital, which can facilitate growth opportunities. </p>
<p>Investors are looking for carve-out opportunities, and a yieldco is a new way to unlock value and raise new equity capital. Another example is OGE and CenterPoint putting together their midstream businesses and looking to take the joint venture public. </p>
<p><b>LeBlanc:</b> Companies are pursuing yieldcos because MLPs are too hard. It will take legislative action to get renewable resources to qualify for MLPs. That’s not going to happen, but people will spend a lot of time trying.</p>
<p>Asset owners are watching the NRG Yield and TransAlta Renewables yieldcos, and saying “me too.” There’s a backlog lining up to get to market. Some will be a good fit, and others will fall by the wayside. But there’s a limited window for these structures. As interest rates go up, yield vehicles will become less attractive.</p>
<p><b>FORTNIGHTLY</b> Utility capex spending has increased in the last couple of years, to a record high in 2012. Do you see these levels continuing? What’s the outlook for new projects, and what factors are at play?</p>
<p><b>Kind:</b> Bonus depreciation mitigated income tax payments for many utilities, and that helped support some capital programs. Looking at EEI data, I see utilities continuing to spend in excess of 2-times depreciation on new capital programs. At that level, utilities will have to raise capital as bonus depreciation ends. And that’s without a lot of new power plants probably being added. If you add substantial power plant activity – which frankly I don’t see happening in the near term – you’d have to dramatically increase the level required. </p>
<p>At what point do companies in a no-growth or low-growth environment think about deferring capex to mitigate the need for rate increases? We saw that happen in the 2007 and ’08 timeframe, with deferrals on capital programs. I don’t think anyone is suggesting demand growth will return at a robust level, as a function of the fact nobody is projecting the economy will grow at a robust level. The economists discuss growth in the 2- to 3-percent range. Further, the Energy Information Administration talks about de-linkage of GDP growth and electricity usage. They’re predicting electricity usage will grow at less than 1 percent per year, and that’s without assuming any substantial change in the way customers behave in the future.</p>
<p><b>Napolitano:</b> I would disagree that we aren’t seeing investment in new power plants. I’ve been involved in activity that indicates lots of people are thinking about natural gas as their transition fuel, and they’re constructing a lot of peaking plants, with combined-cycle projects in process and coming. New projects were finalized in California as a result of an RFP process three years ago, and are coming online now. They’re needed to deal with intermittency of renewables coming onto the grid. In Texas, Panda Power Funds has announced multiple merchant plants and has put together a capital structure to support development financing. In PJM, state contracts for new projects are going through a variety of legal challenges, but the [725-MW] CPV Shore plant in New Jersey recently reached financial closing. Five or six new gas-fired plants cleared in PJM forward auctions on the assumption they’ll get financed and constructed. Many people want to build new gas-fired plants in PJM to deal with capacity requirements.</p>
<p>On the rate-base side, Consumers Energy in Michigan recently announced plans to build a new [700-MW, $750 million] combined-cycle plant. Others are looking at projects too. All incremental baseload power capacity will come from combined-cycle gas turbine plants, in my opinion, whether in competitive wholesale markets or in rate bases. The people who sell this equipment are quite busy with projects right now.</p>
<p><b>Ryan Wobbrock, Moody’s:</b> In general capex is peaking this year and going into 2014 as companies complete the environmental investments they need to comply with EPA’s MATS rules, and to meet renewable portfolio standards for 2015 and 2020. The industry will be turning to an execution strategy, with companies finalizing their large expenditures and trying to catch up with operating costs to make it through to the next rate case.</p>
<p><b>Haggerty, Moody’s: </b>One of the wild cards is environmental capex. There’s a scenario where EPA will impose more onerous regulations going forward. That’s a longer-term issue.</p>
<p><b>Nastro:</b> A large amount of the capex is behind us, and many companies will be focused on an execution strategy in 2014 and 2015. Over the last couple of years, low gas prices and low interest rates have subsidized customer bills and made it easier for regulatory commissions to grant cost recovery with minimal effect on rates. I don’t see any major problems financing capex going forward, especially given the sector’s ability to finance through the financial downturn. However, the lack of top-line growth is obviously a headwind for the sector, as companies contemplate capex investments in the future.</p>
</div></div></div><div class="field field-name-field-article-category field-type-taxonomy-term-reference field-label-above clearfix"><h3 class="field-label">Category (Actual): </h3><ul class="links"><li class="taxonomy-term-reference-0"><a href="/article-categories/stocks-equity-markets">Stocks / Equity Markets</a></li><li class="taxonomy-term-reference-1"><a href="/article-categories/mergers-acquisitions">Mergers &amp; Acquisitions</a></li><li class="taxonomy-term-reference-2"><a href="/article-categories/bonds-debt-markets">Bonds / Debt Markets</a></li></ul></div><div class="field field-name-field-members-only field-type-list-boolean field-label-above"><div class="field-label">Viewable to All?:&nbsp;</div><div class="field-items"><div class="field-item even"></div></div></div><div class="field field-name-field-article-featured field-type-list-boolean field-label-above"><div class="field-label">Is Featured?:&nbsp;</div><div class="field-items"><div class="field-item even"></div></div></div><div class="field field-name-field-image-picture field-type-image field-label-above"><div class="field-label">Image Picture:&nbsp;</div><div class="field-items"><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1310-FEA1.jpg" width="1500" height="1000" alt="" /></div></div></div><div class="field field-name-field-fortnightly-40 field-type-list-boolean field-label-above"><div class="field-label">Is Fortnightly 40?:&nbsp;</div><div class="field-items"><div class="field-item even"></div></div></div><div class="field field-name-field-law-lawyers field-type-list-boolean field-label-above"><div class="field-label">Is Law &amp; Lawyers:&nbsp;</div><div class="field-items"><div class="field-item even"></div></div></div><div class="field field-name-field-tags field-type-taxonomy-term-reference field-label-above clearfix">
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</div>
Thu, 03 Oct 2013 13:42:26 +0000meacott16819 at http://www.fortnightly.comLast Callhttp://www.fortnightly.com/fortnightly/2012/10/last-call
<div class="field field-name-field-import-deck field-type-text-long field-label-inline clearfix"><div class="field-label">Deck:&nbsp;</div><div class="field-items"><div class="field-item even"><p>Utilities are enjoying some of the best financing terms anybody’s ever seen. Is the party winding down?</p>
</div></div></div><div class="field field-name-field-import-byline field-type-text-long field-label-inline clearfix"><div class="field-label">Byline:&nbsp;</div><div class="field-items"><div class="field-item even"><p>Michael T. Burr</p>
</div></div></div><div class="field field-name-field-import-bio field-type-text-long field-label-inline clearfix"><div class="field-label">Author Bio:&nbsp;</div><div class="field-items"><div class="field-item even"><p><b>Michael T. Burr</b> is <i>Fortnightly’s</i> editor-in-chief. Email him at <a href="mailto:burr@pur.com">burr@pur.com</a>.</p>
</div></div></div><div class="field field-name-field-import-volume field-type-node-reference field-label-inline clearfix"><div class="field-label">Magazine Volume:&nbsp;</div><div class="field-items"><div class="field-item even">Fortnightly Magazine - October 2012</div></div></div><div class="field field-name-field-import-image field-type-image field-label-above"><div class="field-label">Image:&nbsp;</div><div class="field-items"><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-fig1.jpg" width="2058" height="925" alt="Figure 1 - 10-Year Bonds" title="Figure 1 - 10-Year Bonds" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-fig2.jpg" width="2060" height="949" alt="Figure 2 - 30-Year Bonds" title="Figure 2 - 30-Year Bonds" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-fig3.jpg" width="2061" height="1183" alt="Figure 3 - Utility Bond Tenors" title="Figure 3 - Utility Bond Tenors" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-fig4.jpg" width="1800" height="1496" alt="Figure 4 - Utility &amp; Power Ratings Snapshot" title="Figure 4 - Utility &amp; Power Ratings Snapshot" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-Tate.jpg" width="1151" height="1085" alt="Rising interest rates and unknown dividend tax policies could be a headwind for utility stocks. –Brian Tate, Wells Fargo Securities" title="Rising interest rates and unknown dividend tax policies could be a headwind for utility stocks. –Brian Tate, Wells Fargo Securities" /></div><div class="field-item odd"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-Nastro.jpg" width="1151" height="1129" alt="Utilities have a significant amount of capex planned in the near term, and bonus depreciation is not a funding strategy. –David Nastro, Morgan Stanley" title="Utilities have a significant amount of capex planned in the near term, and bonus depreciation is not a funding strategy. –David Nastro, Morgan Stanley" /></div><div class="field-item even"><img src="http://www.fortnightly.com/sites/default/files/1210-FEA1-Napolitano.jpg" width="1152" height="1110" alt="There’s good reason to believe there will be a lot of M&amp;A activity around contracted renewable assets in 2013. –Frank Napolitano, RBC Capital Markets" title="There’s good reason to believe there will be a lot of M&amp;A activity around contracted renewable assets in 2013. –Frank Napolitano, RBC Capital Markets" /></div></div></div><div class="field field-name-body field-type-text-with-summary field-label-hidden"><div class="field-items"><div class="field-item even"><p>Utilities today enjoy the lowest all-in financing costs in recent memory. In August 2012, for example, Georgia Power sold $400 million in three-year senior secured notes with a 0.75-percent coupon. At that rate, investors buying those bonds will lose more to inflation than they’ll earn from the bonds—and yet demand for Georgia Power’s paper was so strong the company issued $50 million more debt than it had initially planned.</p>
<p>Indeed, Wall Street for the past couple of years has been throwing a party in honor of power and utility companies. The celebration includes utility stocks, which for a large portion of the past two years have outperformed the broader markets. Few utilities have issued new equity recently, but for those who have, Wall Street rolled out the red carpet.</p>
<p>Some signs, however, indicate the party might be winding down.</p>
<p>For one thing, regulatory commissions in many states are asking tough questions about returns on equity (ROE). The average allowed ROE has been declining for some years, but it’s still in the 10-percent range—even as utility stocks are trading higher than many have for the past decade. Low financing costs combined with high ROEs make for some uncomfortable conversations when utilities appear before regulators to seek rate recovery for capital expenditures.</p>
<p>That discomfort will increase when natural gas prices start rising off today’s rock-bottom $3/MMBtu. Low commodity prices effectively have shielded customers from the effects of rate increases, but the current prices are widely considered unsustainable.</p>
<p>At the same time, utilities face the end of bonus-depreciation policies that have made capital expenditures more affordable for the past two years. As part of the American Recovery and Reinvestment Act of 2009, bonus depreciation provided a 100-percent deduction for property acquired until the end of 2011, and 50 percent in 2012. That allowed utilities to finance a large portion of their capex directly from cash flow, rather than taking on debt or issuing new equity. The end of bonus depreciation might drive many utilities to issue new stock, which will dilute share values.</p>
<p>That’s always a necessary evil, but it comes at an inopportune time. Specifically, dividend tax rates are set to rise dramatically next year, if Congress doesn’t renew the tax cuts it implemented in the early years of the George W. Bush administration. Higher dividend taxes could translate into lower market valuations for utility stocks—compounding the dilutive effect of issuing new equity.</p>
<p>But even if dividend taxes don’t spike—or if a tax hike ultimately has a minor effect on utilities, as some analysts suggest it would <i>(see Frontlines, p.4)</i>—other factors in the market might signal an end to the current cheap-money Bacchanal. Namely, the new Basel III international banking standards are pressuring banks to rein-in loan tenors and increase fees. The European monetary crisis continues to loom over the global economic outlook. And so does the possibility that the U.S. Congress will remain deadlocked in a partisan budget debate, prompting the federal government to impose $109 billion in automatic spending cuts that could break the current fragile recovery and push the economy into full-blown recession.</p>
<p>Of course, even in a recession, utility companies enjoy relatively easy access and favorable terms in the capital markets. But the array of risks now facing the markets brings a measure of sobriety to the finance party. To get a sense of how these risks look from Wall Street, <i>Fortnightly</i> spoke with:<br />• Mike Haggerty, Bill Hunter, and Ryan Wobbrock, Moody’s<br />• David Nastro, Morgan Stanley <br />• Josh Olazabal, PIMCO<br />• Frank Napolitano, RBC Capital Markets<br />• John Whitlock, Standard &amp; Poor’s<br />• Brian Tate, Wells Fargo Securities.</p>
<h4>Money to Spend</h4>
<p><b>Fortnightly: How have the capital markets evolved in the past year, in terms of access, spreads, and terms for power and utility issuers?</b></p>
<p><b>Tate, Wells Fargo:</b> On the debt side, market conditions are as close to perfect as they’ve ever been from a utility-issuer perspective. In 2012, we’re seeing supply [of utility debt securities] on track to be up somewhere around 15 percent over 2011 levels. Utility credit spreads have normalized and cash flows into bonds have been consistent. But there’s a lot of cash to be invested, and not enough supply. Utility bond yields are below the 10-year average. With these attractive debt market conditions, utilities are proactively analyzing their debt portfolios and looking for reasons to issue debt.</p>
<p>In the bank market, liquidity is a popular boardroom topic. There’s good liquidity and strong bank demand for utility assets. Five-year credit facilities are commonplace, but Basel III changes and European debt concerns could pressure tenor and pricing.</p>
<p><b>Whitlock, Standard &amp; Poor’s:</b> Some factors affecting favorable access to capital markets are continued stability in cash flow and low volatility. A lot of that has to do with recovery mechanisms that smooth out cash flow, such as purchased fuel adjustments and other riders that bring cash certainty for utilities. Regulatory outcomes across the sector have been constructive this year, with timely recovery of costs.</p>
<p>On the secured first mortgage bonds that many electrics have issued in the past year, spreads are really tight, and that implies high confidence in receiving repayment of principal if something were to go wrong in the utility’s capital structure. Regulated utilities in general have a variety of investors seeking to hold their debt, and utilities do a good job of laddering their maturities. Many utilities have increased the size and tenor of their facilities this year, compared to previous years.</p>
<p><b>Olazabal, PIMCO:</b> We all know what’s driving the low interest-rate environment: continued sluggishness in the economy. The Federal Reserve is driving a very favorable environment for interest rates. A couple of things affect the utility industry on top of that. In an uncertain environment, investors are moving toward high-quality investments overall. You don’t get much higher quality than utility opco [operating company] or holdco [holding company] bonds, where the underlying entities are strong. So utility bonds have been bid up, and yields are at 2 or 3 percent right now. That’s pretty low, but investors are focused on relative value. With their regulated cash flows, utilities are very strong compared to what else is out there.</p>
<p> </p>
<p><b>Fortnightly: How long can these low interest rates and tight spreads continue? </b></p>
<p><b>Olazabal:</b> I think we’re in a steady state for the most part. If we play forward what we think will happen, it’s more of the same—sluggishness in the economy, a lack of hiring, and continued pressure on the Fed to keep interest rates low. There’s a sense that this can’t go on forever, but it will take a while for things to change.</p>
<p><b>Nastro, Morgan Stanley:</b> In our economists’ view, if Congress fails to act [and resolve the budget crisis], we’ll likely see a decline back into recession in 2013. The vitriol in Washington brings general uncertainty about the ability to find a consensus and avoid the fiscal cliff. The European sovereign debt crisis also is a pressing concern, weighing on the financial markets. Given this backdrop, the broad consensus is that interest rates will likely stay lower for longer, with a slight rise over 12 to 18 months.</p>
<p><b>Fortnightly: How is the situation different for companies with more exposure to merchant risks? </b></p>
<p><b>Whitlock:</b> Access has been good for the higher-rated entities. One thing that investors have looked at is the effect of low natural gas prices, countered to some extent by hedging programs at some companies, and regulated utility operations that contribute to stable cash flow. These are the Exelons and PSEGs of the world. The integrated merchants will perform better than independent power producers because they have plants that will dispatch more on the curve.</p>
<p>For speculative-grade entities, credit quality has deteriorated some. They’re exposed to spot commodity prices and they avoid hedging because they’re searching for higher profits. Low prices obviously hurt them. The pure merchant companies, such as GenOn and Energy Futures Holdings (EFH), are strongly affected by the forward price curve. A company like EFH has refinancing risk with maturities coming in, and it depends on coal, which isn’t stacking up well against gas.</p>
<p><b>Olazabal:</b> There’s a bifurcation in the market. Over the last three to five years, a lot of longer-term investors, especially institutional investors, have gone underweight on utility holdcos and gencos, on the belief that as long as you have a surplus of gas and suppressed power prices, there’s a big downside risk to holdcos and gencos. There’s a widespread belief now that gas and power prices are stabilizing, and there’s light at the end of the tunnel for gencos and the holdcos that own them. We have seen a good deal of tightening [in spreads] on those bonds. However, even when they stabilize, some companies will have 12 or 18 months of hedges that need to be re-marked, with pressure on earnings as a result. So it’s too early to tell if it’s correct, but there’s a sense that we’re close to the bottom in the merchant markets.</p>
<p><b>Haggerty, Moody’s:</b> Merchant power companies have had no trouble accessing the capital markets, but they need a recovery in power prices. At this point they’re hunkering down, trying to conserve liquidity and hang in there until power prices increase.</p>
<p><b>Fortnightly: What’s happening in the project finance market? How are non-recourse power and gas deals getting funded? </b></p>
<p><b>Nastro:</b> We’ve seen a pullback in the traditional bank market, and the capital markets have stepped up to fill the void. The traditional project finance bank market is significantly weaker and has become more fragmented. Pricing has increased and tenors have contracted, largely because of Basel III requirements and bank credit downgrades. The Eurozone banking crisis has caused many European banks to reduce their lending activity significantly, and in some cases to exit the project finance business entirely. Fewer banks are providing capital, and generally are lending only to core relationship clients.</p>
<p>Given this backdrop, the capital markets have filled the need. Demand for structured credit is robust. In the structured bond market, we’ve seen the majority of U.S.-based projects’ debt trading in the 5.5 to 6.5-percent range. For comparison, yields of BBB-minus rated corporate bonds are around 4.5 percent. The capital markets have been very receptive to alternatives like project bonds that offer incremental yield.</p>
<h4>Gas Bubble</h4>
<p><b>Fortnightly: For regulated utilities, what are the implications of low gas and power prices? Is it only a positive story, as prices have helped keep customers’ bills low? </b></p>
<p><b>Olazabal:</b> There’s much more attention being paid to how various commodities affect utilities, even fully regulated ones. You see this at all the industry meetings and in conversations with management teams. They’re paying more attention to the impact of shale gas, and how this transformational, paradigm shift affects where you’re putting your generation investment—what type you’re going to build, what gets retired, and when.</p>
<p>Five years ago, all the talk was about coal and potentially IGCC and a nuclear renaissance. That’s been stopped in its tracks, not because of any consensus about the right way to go, but what’s happened on the gas side. You now have an industry that’s driven much more by broader commodity trends. The days of building a generating portfolio on a 20-year plan are over.</p>
<p><b>Napolitano, RBC Capital Markets:</b> We’re seeing the next evolutionary stage, the re-gasification of the industry to meet the implied goals of 2001-era deregulation.</p>
<p>If you look back at the market modeling performed by experts in the space around 2001, you’ll see they forecast a change in the supply stack. It included the retirement of nuclear and coal plants, and continued building of combined-cycle gas-fired plants, with really no renewables in the mix. Ten years later, what do we have? Life-extensions associated with nuclear, and very few shutdowns. The court’s CSAPR decision leaves the issue uncertain, but you still see economic shutdowns of coal plants driven by regulations and also by the lack of power price support. You see all these renewable plants coming on the grid, wind and solar predominately, and people are talking about gas-fired plants again.</p>
<p>The new gas-fired plants can be built on a regional basis, to replace retiring coal plants. But in other cases it will be easier to build localized generation rather than plants that require multi-state transmission lines—some of which are being canceled. Some projects in PJM recently were canceled after five or six years of planning. <i>[Editor’s note: PJM’s board at the end of August removed the $1.2 billion Mid-Atlantic Power Pathway (MAPP) and $2.1 billion Potomac-Appalachian Transmission Highline (PATH) projects from its planning queue.] </i></p>
<p> </p>
<p><b>Fortnightly: What do you see as the outlook for renewables in this environment? There’s a lot of uncertainty about federal incentives, but still strong public support for renewables. </b></p>
<p><b>Napolitano:</b> The question is, are we at the end of the renewable renaissance? As we head into the election and look at the pancaking of costs—and the lack of economic recovery, which would let people focus less on expenses and more on revenues—it’s getting harder to find support for renewables. Post-Solyndra, it’s a question of whether any federal subsidy, either direct or indirect, will be available for future tranches of renewable construction.</p>
<p><b>Fortnightly: During the Bush administration some states increased their RPS goals and pursued climate-change policies, partly in reaction to federal inaction. Might that happen again? </b></p>
<p><b>Napolitano: </b>No state is in a healthy situation to make up the difference. In fact, as the economy continues performing weaker than planned, states might start to question their RPS goals and timelines. If we start to see states compromising on those goals, and if you take away the revenue contracts, there’s no hope of building new projects. The whole thing will come to a halt. Already some U.S. manufacturers are scaling back production lines and laying off workers, and globally we’re seeing bankruptcies among manufacturers of equipment.</p>
<p>This could become an environment where the strong simply eat the weak in the renewable space. Prime assets will be those that are up and running and are past the early period when the tax-attribution portion mattered most. These plants will have true operating cash flow and a contract with 15-plus years remaining. The buyers could be power companies, pension funds, or perhaps public market investors, through IPO vehicles. Also European and Canadian companies still see the U.S. as a good strategic market, and they could harvest those renewable assets. There’s good reason to believe there will be a lot of M&amp;A activity around contracted renewable assets in 2013.</p>
<p><b>Olazabal:</b> Institutional investors are asking if [the roll back of renewable incentives] means there’s an opportunity in the market. Even if wind goes away, there’s a lot of interesting action in solar. There’s definitely a hunger among fixed-income investors. They haven’t had access to these types of projects before, and many large institutional investors are very focused on environmental and social issues. They’d love to see more of those types of deals.</p>
<p>Counterparties are trying to figure out what they’ll look like. It’s a nascent market now, but a couple of big solar project bond deals have been relatively well received. It’s like the heyday of the independent power industry, when institutional investors were getting comfortable with the idea of standalone non-recourse projects, and what they meant in terms of due diligence, offtaker risks, and EPC contracting. Who will be the Bechtel or Fluor of the solar industry? Nobody knows yet, but they’ll bring a track record of getting projects done, and that will make investors more comfortable. It’s exciting; a business model is emerging.</p>
<h4>Creeping Leverage</h4>
<p><b>Fortnightly: What’s the equity market outlook for power and utility companies? </b></p>
<p><b>Tate:</b> The outlook vacillates, contingent on what will happen with the overall economy. Utility stocks have been a safe haven, outperforming during market volatility and underperforming during market advances. As the U.S. economic recovery picks up steam, we could see non-traditional utility investors exiting the sector as inflation kicks in. Rising interest rates and unknown dividend tax policies could be a headwind for utility stocks.</p>
<p><b>Nastro:</b> Utility valuations are close to their 10-year highs, but we haven’t seen a significant amount of equity issuance from the sector. That’s because utilities largely took advantage of bonus depreciation. Now, as the sun likely sets on bonus depreciation, we expect to see more equity issuance from the sector as we go into 2013. Utilities have a significant amount of capex planned in the near term, and bonus depreciation is not a funding strategy.</p>
<p>If there’s a complete rollback on dividend taxes to pre-Bush rates, the rate would return to 39.5 percent. If you fully load that with the health-care surtax, the top dividend tax rate would be 43.4 percent. Should that scenario play out, we may see a potential compression in PE [price-to-earnings] multiples of 1 to 1.5 percent for many utility companies.</p>
<p>Companies now are asking the question: given where prices are today, given the potential headwinds in the macro economy, and given robust capital needs, should we consider pre-funding our 2013 and 2014 equity needs? <i>(See “Pay it Forward.”) </i></p>
<p> </p>
<p><b>Fortnightly: Utilities are in the middle of a wave of capital spending, at a time of weak demand and low power prices. Is that putting pressure on balance sheets? </b></p>
<p><b>Hunter, Moody’s: </b>Actually C&amp;I demand has increased moderately. It’s not back to where it was pre-recession, but it has increased. There has been a notable weakness in residential demand, but it’s hard to figure out how much of that is due to mild weather and conservation, and how much is due to the weak economy. However, despite middling demand and low power prices, overall we expect the industry will get reasonably timely recovery. The regulatory compact is still intact.</p>
<p><b>Haggerty, Moody’s:</b> Low interest rates and low fuel costs help a lot. But it depends on what the capex is for and what mechanisms are in place at the state level. Capex has been coming for a while, in fits and starts. CSAPR has been delayed, and that’s given some utilities more time to comply. The other area is transmission capex, which generally benefits from reasonably high ROEs, because it’s mostly FERC regulated. But in selective circumstances, when a small utility is building a big generating asset, there will be some pressure on rates. An example is Mississippi Power, which is a relatively small operating utility building an IGCC plant. That will put pressure on rates in the neighborhood of 30 percent or higher.</p>
<p>Capex needs are more of an issue for unregulated companies. There’s no way for them to cover environmental capex, especially when power prices are low.</p>
<p><b>Olazabal:</b> One thing that fixed-income investors are really focused on is environmental regulations—what shape they’ll take as they develop. CSAPR has been pushed out or removed, but we still face mercury regulations. The standards aren’t likely to get lighter from here. Depending on the outcome of the elections, maybe things won’t be as severe, but I don’t think many people realistically envision a return to a more lenient emissions environment. So the question is how much capital will be required? What will be the impact on the generation fleet? Are companies able to handle the incremental financing need? What’s the impact on the credit profile?</p>
<p><b>Whitlock:</b> One thing we’re looking at harder in 2013—unless something happens between now and the end of the year, it looks like bonus depreciation will end. It’s been a great source of funds for companies, so they don’t have to issue large amounts of new debt. We might see a period of creeping leverage, which could affect credit quality. I think it’s too early to see where we’re headed with that, and whether utilities will balance out their debt with coverage from cash flow. The key thing is how quickly utilities can recover cash from their new investments, to generate free cash flow.</p>
<p><b>Fortnightly: Approved returns on equity (ROE) are coming under pressure. Some analysts suggest utilities’ approved ROEs could fall by between 25 and 75 basis points in the next round of rate cases. What do you see happening in approved ROEs, and what are the implications? </b></p>
<p><b>Olazabal:</b> Downward pressure on allowed ROE is to be expected in this declined interest rate environment. The spread on allowed ROE is close to or near historic highs, and I think commissions are reacting naturally with some reductions. To date those reductions seem moderate and reasonable. Most utilities can handle a reduction without much material effect on the credit profile.</p>
<p><b>Nastro:</b> Low fuel prices have largely offset customer rate increases, so regulators haven’t pushed down ROEs as fast as they might otherwise in a historically low U.S. Treasury environment. There’s a significant amount of capex that needs to go into rates, and there likely will be customer push-back. As more utilities head into rate cases, the questions will involve how well they can defend existing ROEs and manage the regulatory process. Given the macro environment, the numbers are likely to come down.</p>
<p><b>Tate:</b> The thing to watch is rising interest rates. Interest rates can increase rapidly, and they have in the past. But rate cases involve long-term decisions. If you receive a lower ROE based on assumed capital costs, and you find yourself in a rapidly rising interest rate environment, it could pressure your returns.</p>
<h4>Seeking Value</h4>
<p><b>Fortnightly: What’s the outlook for M&amp;A—both for corporate mergers and also asset sales? </b></p>
<p><b>Nastro:</b> We still see catalysts in place for increased strategic activity—drivers such as scale and scope, earnings growth, diversification and rebalancing the business mix, as well as succession planning.</p>
<p><b>Napolitano:</b> When rate cases are open, it’s not a good time to announce mergers. Given the nature of rate cases that need to be filed in the next year or the next three years, you won’t see a lot of mergers of equals. You will, however, see sales of properties that aren’t core to the seller’s multi-state strategy. Live auctions on the street today include assets where a company is looking to get out of a state, or doesn’t feel it needs to be in the distribution business any longer.</p>
<p>Also we’ve seen a lot of internal succession planning, and a new crop of CEOs stepping in. It’s not typical for a new CEO to engage in M&amp;A. Instead you’ll see them getting a couple of years of track record, and figuring out where they want to put their stamp on the company.</p>
<p>The next wave of mergers might be driven by growth rates in different economic regions. If a certain region is growing faster and you have trouble dealing with that growth, you might need a bailout partner or a big brother. And if you’re achieving higher valuation than your peers, acquiring a smaller company in a growing region might position you for growth as the economy catches up to the region.</p>
<p>On the unregulated side, I see lots of potential for consolidation in a very fragmented sector. The NRG-GenOn merger is an example of companies going for greater scale, putting assets under a strong management team, and managing a larger portfolio. Some companies are testing the market for valuation on fossil power plants and portfolios. Hybrid companies are thinking of changing strategies and focusing on rate-base cash flows.</p>
<p><b>Fortnightly: Won’t low power prices slow down asset sales? </b></p>
<p><b>Napolitano:</b> Buyers who are going to take that risk will build in a risk-reward balance. But I don’t think it will shake out that clearly. We’re in a permanent state of uncertainty, which means that one has to use common sense. In vertically integrated markets like the Midwest, the Pacific Northwest, and the Southeast, utilities have the opportunity to acquire former independent power plants, where the PPA has run off and there’s no option for the owner but to re-contract. In those cases, assets will be sold for very low prices.</p>
<p><b>Nastro:</b> We continue to see interest from strategic as well as financial players in buying generating assets. There haven’t been a lot of gas-fired plants with long-term PPAs on the market over the last couple of years, and that scarcity has pushed many investors to look at merchant assets more than in the past. We see interest from strategic buyers who are betting on a recovery. If you look at recent valuations, buyers are putting higher valuations on near-term cash flows than would be implied by forward curves. Those assets are being valued more highly by private buyers, who are willing to weather the market and ride out the recovery.</p>
<p>Also, the market is rewarding execution of a clear strategic vision by sellers who look to focus on their core business. Regulated companies continue to trade at a premium to hybrid companies, which encourages companies to reconsider divesting non-core or underperforming assets. In divestitures over the last 24 months, we’ve seen the sellers’ stock price outperform. Two years ago Pepco sold its Conectiv generating assets, and the subsequent expansion in Pepco’s P/E multiple more than offset the earnings dilution associated with the divestiture. More recently Dominion announced that it was considering divesting three merchant assets, and the company’s stock price responded favorably.</p>
<p><b>Fortnightly: Some large mergers have been completed or moved forward in the past year. What lessons can we learn from these deals? </b></p>
<p><b>Wobbrock, Moody’s:</b> One lesson might be to offer up a pound of flesh from the beginning. For example, in acquiring Central Vermont Public Service, Gaz Métro offered significant customer savings, and it seemed to understand how to approach the commission and interveners. Another example is Fortis acquiring Central Hudson Gas &amp; Electric. They proposed a plan to the commission, and it remains to be seen whether the commission thinks what they offered is enough or whether they’ll want more.</p>
<p><b>Hunter:</b> It’s no surprise that states are taking their pound of flesh. They want to extract benefits for ratepayers before they’ll approve transactions, and companies go into deals expecting that to happen. The surprises in the latest round of mergers, however, have come from FERC, which has been more stringent in its market power determinations than had been expected. That was a surprise particularly for the Duke-Progress merger but also to a lesser extent for Exelon-Constellation. They thought selling the plant portfolio in Maryland would be sufficient, but FERC put more strictures on it and imposed a time frame that made it more expensive.</p>
<p>The same factors, as far as we can tell, shouldn’t necessarily be a deterrent for other mergers. For GenOn and NRG, for example, the two companies operate in very disparate geographies. There’s some overlap in New York but none in PJM, where FERC’s market power concerns primarily focused.</p>
<p><b>Nastro: </b>It’s difficult to extrapolate a trend from just a few data points. The Duke-Progress and Exelon-Constellation situations were case-specific, but FERC is being more assertive and that’s more of a consideration now when contemplating a merger. However, states continue to be receptive to M&amp;A as a way to mitigate potential rate increases. That’s an important reason why we’ve seen a more constructive regulatory environment at the state level.</p>
<p>Companies are stressing the strategic value of the combination, the benefits of balance-sheet strength and credit quality, so acquisition premiums have come down. Credit quality continues to be emphasized with the majority of corporate deals being stock transactions without incremental leverage.</p>
<p><b>Tate:</b> In the big picture, the volume of announced utility M&amp;A has slowed in 2012. There were over $40 billion in announced utility transactions in 2011, and in 2012 the number is significantly lower. But having said that, there’s a lot of active M&amp;A dialogue occurring behind the scenes. Key drivers are the desire for increased scale, a greater focus on regulated operations, and enhanced growth opportunities. Financial scale has gained importance in recent M&amp;A deals, rather than operating synergies.</p>
<p>Also, over the last couple of years we’ve seen a couple of trends emerging. First, Canadian utilities have shown significant interest in acquiring U.S. utilities. Since 2010, 10 of 25 deals have involved Canadian buyers. This is driven by attractive acquisition opportunities, but also there’s a valuation arbitrage; Canadian publicly traded utilities trade at premiums compared to their peers in the United States, so they can pay a higher premium and a deal can still be accretive. And allowed ROEs for U.S. utilities are frequently 100 to 150 basis points higher than they are for Canadian utilities.</p>
<p>The other trend is a move toward larger regulated operations and lower business risk. These drivers are pushing smaller utilities to consider consolidation. And overlying all of this, the capital markets remain open, providing attractive acquisition capital.</p>
</div></div></div><div class="field-collection-container clearfix"><div class="field field-name-field-sidebar field-type-field-collection field-label-above"><div class="field-label">Sidebar:&nbsp;</div><div class="field-items"><div class="field-item even"><div class="field-collection-view clearfix view-mode-full field-collection-view-final"><div class="entity entity-field-collection-item field-collection-item-field-sidebar clearfix">
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<div class="field field-name-field-sidebar-title field-type-text field-label-above"><div class="field-label">Sidebar Title:&nbsp;</div><div class="field-items"><div class="field-item even">Pay It Forward</div></div></div><div class="field field-name-field-sidebar-body field-type-text-long field-label-above"><div class="field-label">Sidebar Body:&nbsp;</div><div class="field-items"><div class="field-item even"><!--smart_paging_autop_filter--><!--smart_paging_filter--><p>One way that some utilities have been getting ahead of market changes is by issuing equity to pre-fund costs they expect to incur later. This generally takes two forms: equity forward contracts, and mandatory convertible offerings. Examples include Pepco Holdings, which sold about $350 million in shares on a forward basis in March, and PPL, which sold about $270 million in April. Also, NextEra Energy issued $600 million in three-year, mandatory convertible bonds on May 1, and another $650 million in September.</p><p>Both approaches carry a premium, but they allow utilities to capture today’s high stock prices in a forward sale. And some issuers have found banks hungry enough to participate in equity deals that they’ll take a substantial haircut for the opportunity. <i>(See “<a href="http://www.ifre.com/bofa-merrill-loses-us$12m-on-bought-convert/21015386.article" target="_blank">BofA loses $12m on bought convert</a>,” IFR 1932, May 2012.)</i></p><p>However, terms likely will normalize as soon as the current confluence of forces drives utilities back into the equity markets in earnest.–<em><strong>MTB</strong></em></p></div></div></div> </div>
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<div class="field-label">Tags:&nbsp;</div>
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<a href="/tags/capital-markets">capital markets</a><span class="pur_comma">, </span><a href="/tags/financing-trends">financing trends</a><span class="pur_comma">, </span><a href="/tags/edison-electric-institute-financial-conference">Edison Electric Institute Financial Conference</a><span class="pur_comma">, </span><a href="/tags/georgia-power">Georgia Power</a><span class="pur_comma">, </span><a href="/tags/return-equity">Return on equity</a><span class="pur_comma">, </span><a href="/tags/roe">ROE</a><span class="pur_comma">, </span><a href="/tags/american-recovery-and-reinvestment-act">American Recovery and Reinvestment Act</a><span class="pur_comma">, </span><a href="/tags/capex">CapEx</a><span class="pur_comma">, </span><a href="/tags/george-w-bush">George W. Bush</a><span class="pur_comma">, </span><a href="/tags/basel-iii">Basel III</a><span class="pur_comma">, </span><a href="/tags/mike-haggerty">Mike Haggerty</a><span class="pur_comma">, </span><a href="/tags/bill-hunter">Bill Hunter</a><span class="pur_comma">, </span><a href="/tags/ryan-wobbrock">Ryan Wobbrock</a><span class="pur_comma">, </span><a href="/tags/moody%E2%80%99s">Moody’s</a><span class="pur_comma">, </span><a href="/tags/david-nastro">David Nastro</a><span class="pur_comma">, </span><a href="/tags/morgan-stanley">Morgan Stanley</a><span class="pur_comma">, </span><a href="/tags/josh-olazabal">Josh Olazabal</a><span class="pur_comma">, </span><a href="/tags/pimco">PIMCO</a><span class="pur_comma">, </span><a href="/tags/frank-napolitano">Frank Napolitano</a><span class="pur_comma">, </span><a href="/tags/rbc-capital-markets">RBC Capital Markets</a><span class="pur_comma">, </span><a href="/tags/john-whitlock">John Whitlock</a><span class="pur_comma">, </span><a href="/tags/standard-poors">Standard &amp; Poors</a><span class="pur_comma">, </span><a href="/tags/brian-tate">Brian Tate</a><span class="pur_comma">, </span><a href="/tags/wells-fargo-securities">Wells Fargo Securities</a><span class="pur_comma">, </span><a href="/tags/liquidity">liquidity</a><span class="pur_comma">, </span><a href="/tags/federal-reserve">Federal Reserve</a><span class="pur_comma">, </span><a href="/tags/opco">opco</a><span class="pur_comma">, </span><a href="/tags/holdco">holdco</a><span class="pur_comma">, </span><a href="/tags/exelon">Exelon</a><span class="pur_comma">, </span><a href="/tags/pseg-0">PSEG</a><span class="pur_comma">, </span><a href="/tags/genon">GenOn</a><span class="pur_comma">, </span><a href="/tags/energy-futures-holdings">Energy Futures Holdings</a><span class="pur_comma">, </span><a href="/tags/efh">EFH</a><span class="pur_comma">, </span><a href="/tags/genco">genco</a><span class="pur_comma">, </span><a href="/tags/project-finance">Project finance</a><span class="pur_comma">, </span><a href="/tags/eurozone">Eurozone</a><span class="pur_comma">, </span><a href="/tags/igcc">IGCC</a><span class="pur_comma">, </span><a href="/tags/csapr">CSAPR</a><span class="pur_comma">, </span><a href="/tags/rps">RPS</a><span class="pur_comma">, </span><a href="/tags/pepco">PEPCO</a><span class="pur_comma">, </span><a href="/tags/nextera">NextEra</a><span class="pur_comma">, </span><a href="/tags/epc">EPC</a><span class="pur_comma">, </span><a href="/tags/equity">equity</a><span class="pur_comma">, </span><a href="/tags/ci">C&amp;I</a><span class="pur_comma">, </span><a href="/tags/asset-sales">asset sales</a><span class="pur_comma">, </span><a href="/tags/conectiv">Conectiv</a><span class="pur_comma">, </span><a href="/tags/dominion">Dominion</a><span class="pur_comma">, </span><a href="/tags/central-vemont-public-service">Central Vemont Public Service</a><span class="pur_comma">, </span><a href="/tags/gaz-metro">Gaz Metro</a><span class="pur_comma">, </span><a href="/tags/fortis">Fortis</a><span class="pur_comma">, </span><a href="/tags/central-hudson-gas-electric">Central Hudson Gas &amp; Electric</a><span class="pur_comma">, </span><a href="/tags/ferc">FERC</a><span class="pur_comma">, </span><a href="/tags/constellation">Constellation</a><span class="pur_comma">, </span><a href="/tags/nrg">NRG</a><span class="pur_comma">, </span><a href="/tags/pjm">PJM</a> </div>
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Fri, 05 Oct 2012 14:56:31 +0000puradmin14783 at http://www.fortnightly.com